An official in the enforcement division of the Securities and Exchange Commission said late last month that the agency has its eye on several private-equity industry practices that could disadvantage investors, such as the charging of deal fees and cherry-picking of deals.
Speaking in New York City at a conference hosted by Private Equity International on Jan. 23, Bruce Karpati, the chief of the SEC enforcement division's asset management unit, observed that the agency has been bringing more cases involving private-equity firms or "private equity-like issues."
He pointed to eight recent cases, including ones involving employees of advisory firm Adams Street Partners and private-equity firms Brantley Capital, Onyx Capital and TPG Capital. The accusations range from insider trading to misappropriating funds, to usurping investment opportunities, to outright stealing.
"Much of the improper conduct in private equity arises out of conflicts of interest, which can lead to misappropriation, deal cherry-picking and other forms of misconduct," Karpati said. In addition, Karpati pointed to the overhang of capital available to be put to work by buyout firms as a potential "stressor," since it "means that there is more capital chasing the same number of deals, which puts extra pressure on returns."
This, in turn, has led to an environment where many firms are fighting to survive and which could "incentivize managers to engage in aggressive marketing, and may lead some to cross the line into inappropriate behavior," he said.
Karpati went through several potential conflicts of interest that are of particular concern to the SEC:
- Karpati observed that the interests of management companies and investors, such as in the setting of management fees, can diverge at all firms. But, he said, the conflict "may be particularly acute" at firms that have listed their shares on public exchanges and are, therefore, subject to pressures from shareholders to produce short-term gains.
- In their partnership agreements, private-equity shops spell out what expenses are absorbed by the management company and which ones are absorbed by the fund. Nevertheless, the commission is concerned that, in some cases, firms may be using the buying power of their funds to secure lower prices on services "at the expense" of investors.
- Buyout firms often charge portfolio companies fees for investment banking, consulting and other services. Karpati said that the agency is concerned about the charging of such fees "where the allowable fees may be poorly defined by the partnership agreement."
- In recent years, many of the largest buyout shops have become diversified asset managers, offering a growing list of products and (in some cases) offering better terms for favored investors that make especially big commitments. Some of the "troubling behavior" that has resulted, said Karpati, includes the "improper shifting of organizational expenses, where commingled vehicles foot the bill for preferred clients." In addition, Karpati suggested advisers may be making fund commitments through one vehicle "to create deal flow for a more profitable co-investment vehicle."
Just how tough the SEC will get on such conflicts and the bad behavior that can result from them remains to be seen. But it's clear the agency has gotten up to speed on an industry that some accused it only a few years ago of not understanding.
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